Portfolio vs Asset Allocation…potential pitfalls

Many financial planners recommend their clients follow a particular Strategic Asset Allocation that may be based on the output of the combination of a risk profile as well as matching the client’s needs. For example, a popular strategic asset allocation for a “balanced” portfolio may be along the lines of…

Australian Shares 35%

Global Shares 25%

Property 10%

Bonds 20%

Cash 10%

or in simple terms, the “balanced” portfolio contains 70% ‘growth’ assets and 30% ‘defensive’ assets (i.e. cash plus bonds). Whilst this overall asset allocation appears simple enough, unfortunately when the underlying investments are chosen, inadvertently, they often increase the portfolio risk beyond that of the Strategic Asset Allocation’s risk. This is because the overall risk of the Strategic Asset Allocation is based on broad-based indices but our investmen portfolio may significantly deviate from them…for our “balanced” asset allocation the indices may be…

S&P/ASX 200 Accumulation index

MSCI World Index (Unhedged)

S&P/ASX 200 A-REIT Accumulation Index

UBS Composite All Maturities

UBS Bank Bill

…but our portfolio may contain Australian shares outside the top 200, or may have high exposure to Emerging Markets or exposure to Growth Shares. Also, perhaps the property allocation contains global REITs, and the fixed interest has a high proportion of credit. There may be other risks in the portfolio from hedge funds, long/short funds, commodities, or perhaps a very high proportion of mezzanine finance. If an investment portfolio contains these exposures then whilst they may add up to the stated proportions of the Strategic Asset Allocation, compared to the above-mentioned indices the final portfolio will undoubtedly carry significantly more risk…and also more cost from higher than index fees.

So if risks are embraced over and above the Strategic Asset Allocation’s, then it may require an increase in allocation to the more defensive allocation of cash and bonds. If credit is added to the portfolio, reduce some equities or property; if there is a large small cap allocation in Australian Shares, perhaps the overall Australian shares allocation needs to be reduced.

So please keep in mind that a recommended Strategic Asset Allocation is based on cheap simple index funds and if your portfolio has different risks to these traditional indices then it may have more risk than you realise…more return potential sure, but more loss potential too.